Macroeconomics 9: The basics of Short-run Macroeconomics

Question 1

Set the scene for the basics of short-run macroeconomics

Answer 1

The key insight is that, in the short-run, prices are fixed (sticky)
Aggregate Demand determines real output and supply adjusts to the level of demand.
We will use the long-run model expressions for the components of demand for goods:
consumption (slightly adjusted), investment, government expenditure, net exports (open
economy).
Because prices of goods are fixed, there is a role for money in influencing aggregate
demand and hence having short-run effects on the real economy. The mechanisms are:
Through the exchange rate for a small open economy with open capital markets
(Mundell-Fleming model)
Through both interest rate and exchange rate for a large open economy with open capital
markets

Question 2

Describe sticky prices in the short run

Answer 2

Why should prices be rigid in the short run?
- because of the way firms set prices
- because of the way in which nominal wages are determined
Not all prices are sticky in the short run e.g. commodity and financial asset prices
* Firm pricing behaviour:
1. menu costs
2. search behaviour - ‘Search behaviour’ says that when consumers want to buy goods n services, they might do a deep search for the product at an optimal price. This introduces search models where consumers are faced with a whole range of prices. But once the consumer chooses a certain supplier, they’re more likely to ‘stick’ to the supplier for future purchases cos they ‘trust’ them. If this ‘stickiness’ exists, then firms must realise that if they increase prices, consumers might go to another supplier. So in the short-run, firms are reluctant to change prices, constributing to why prices are sticky in the short-run. Also, when we have more unemployment. firms can increase productivity without increasing wages and thus prices
3. coordination failure - In reality, firms operate in a segmented market - monopolistic competition - firms produce goods in a sorta contained way and their are all sorts of consumers for a particular good and firms try to have a USP. This contributes to ‘sticky prices’ because if a certain niche increases prices, other firms may not do so as they aren’t the EXACT same product (so don’t have to follow the same equilibrium) and so that firm loses customers
* Wage-setting behaviour
* (implicit) contracts keep workers in jobs and (nominal) wages relatively fixed
* efficiency wages make it costly for firms to reduce wages
* trade unions and legal structures can slow wage adjustment in the short run